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Author Accepted Manuscript AUTHOR ACCEPTED MANUSCRIPT FINAL PUBLICATION INFORMATION On Egypt's de facto Integration in the International Financial Market The definitive version of the text was subsequently published in Middle East Development Journal, 7(2), 2015-09-29 Published by Taylor and Francis and found at http://dx.doi.org/10.1080/17938120.2015.1083219 THE FINAL PUBLISHED VERSION OF THIS MANUSCRIPT IS AVAILABLE ON THE PUBLISHER’S PLATFORM This Author Accepted Manuscript is copyrighted by World Bank and published by Taylor and Francis. It is posted here by agreement between them. Changes resulting from the publishing process—such as editing, corrections, structural formatting, and other quality control mechanisms—may not be reflected in this version of the text. You may download, copy, and distribute this Author Accepted Manuscript for noncommercial purposes. Your license is limited by the following restrictions: (1) You may use this Author Accepted Manuscript for noncommercial purposes only under a CC BY-NC-ND 3.0 IGO license http://creativecommons.org/licenses/by-nc-nd/3.0/igo. (2) The integrity of the work and identification of the author, copyright owner, and publisher must be preserved in any copy. (3) You must attribute this Author Accepted Manuscript in the following format: This is an Author Accepted Manuscript by Alnashar, Sara B. On Egypt's de facto Integration in the International Financial Market © World Bank, published in the Middle East Development Journal7(2) 2015-09-29 CC BY-NC-ND 3.0 IGO http://creativecommons.org/licenses/by-nc-nd/3.0/igo http://dx.doi.org/10.1080/17938120.2015.1083219 © 2021 World Bank On Egypt’s de facto integration in the international financial market Sara B. Alnashar The World Bank Group, Cairo, Egypt Received 14 April 2015; accepted 23 July 2015 The author is very grateful to Professor Peter Montiel, Williams College, who was the supervisor of unpublished academic work upon which this paper builds. Thanks go to Professor Peter Pedroni, Williams College, and Professor Alaa El Shazly, Cairo University, for useful discussions on empirical issues, and to Professor Omneia Helmy, Egyptian Center for Economic Studies and Cairo University, as well as Dr. Magda Kandil, International Monetary Fund, for helpful remarks, and to Dr. Hoda Selim, Economic Research Forum, for sharing useful resources, and to Dr. Salwa El-Antary for important clarifications regarding the history of Egypt’s financial system, and to two anonymous referees for constructive comments and suggestions. Any errors remain the responsibility of the author. Comments and suggestions are welcome at [email protected]. I. INTRODUCTION Egypt has been gradually dismantling legal restrictions on the entry and exit of capital flows since the early 1990s. Since then, the economy has been experiencing intermittent episodes of capital inflows and outflows. Most remarkably, in the wake of the international financial crisis of late 2008, the capital and financial account of Egypt’s balance of payments was hit hard as inflows dropped drastically. Net portfolio investment in Egypt decreased by a staggering 570 percent to reach an outflow of more than $9.2 billion in 2008/09. This was reversed to achieve a net inflow in the following year, but once again returned to a net outflow of $2.6 billion in 2010/11 due to the uncertainty brought about by the January 25th revolution. On the one hand, the volatility that portfolio investments have been exhibiting may point to a high degree of international financial integration/capital mobility. But on the other hand, preliminary assessment of the rates of return on financial assets in Egypt shows that their behavior is secular from that of its foreign counterparts. That is, a large and varying differential exists between the rates of return on domestic and foreign financial assets, which is inconsistent with a high level of financial integration/capital mobility. Given such contradicting observations, how well is the Egyptian economy de facto integrated in the world financial market? And does capital mobility complicate the actions of the Central Bank of Egypt in a way that would inhibit monetary autonomy (especially since the exchange rate has been quite stable in Egypt even after the announced floatation in January 2003)? Moreover, while Egypt has become de jure financially open, what explains the persistence of this differential between return rates on domestic and foreign financial assets? Answering these questions is important to understanding how the macroeconomy works. The domestic policies’ effectiveness in changing aggregate demand is determined— among other factors—by the degree of the economy’s international financial integration. This notion could be better explained in light of the impossible trinity. A country that has a pegged exchange rate and a high degree of capital mobility will have no autonomous monetary policy. On the other hand, a country that has a floating exchange rate and a high degree of capital mobility will be able to conduct an autonomous monetary policy, but high capital mobility would imply bigger fluctuations in the exchange rate in response to monetary shocks (Mundell 1963; Fleming 1962; Dornbusch 1976). Further, the volatility in financial assets’ returns may generate inflows and profit opportunities to foreign investors (from arbitrage), but may be destabilizing to the economy (Balli, Basher and Rana 2014). 1 In light of the above, the objective of the paper is two-fold: first, to formally test whether Egypt has become de facto financially open after the steps taken towards the de jure liberalization of the capital and financial account of the balance of payments;1 second, to explain the presence of the large and varying rate of return differential between domestic and foreign financial assets. For the first objective of this study, we ran two empirical tests: the uncovered interest parity (UIP) test and a monetary autonomy test. Using monthly data, the UIP failed to hold, as the exchange rate-adjusted differential between Egyptian 3-month Treasury bill rates and the US counterpart has been found to be non stationary for the whole period under study (January 2000-December 2011) and for the shorter period that witnessed large capital inflows (July 2004–June 2008). Also, the monetary autonomy test has shown that the growth rate in the monetary aggregate (M2) Granger-causes movements in the exchange rate-adjusted differential for the whole period under study, as well as the shorter period of high capital inflows. This means that despite the stable exchange rate, and the de jure capital and financial openness, the Central Bank of Egypt has been capable of stimulating changes in the domestic interest rate. This means that monetary autonomy has been preserved. The UIP and monetary autonomy tests both point to imperfect international financial integration for Egypt. For the second objective of this study, initially we test for the presence of a long-run equilibrium relationship between the interest rate differential and its potential macro determinants. For the period 2001/02–2010/11, using quarterly data, cointegration was detected between the following five variables: (1) nominal interest rate spread between Egyptian and US 3-month Treasury bill rates, (2) log of the bilateral exchange rate (LE/$), (3) differential between logs of monetary aggregates (M2) in Egypt and the US, (4) differential between the logs of real output in Egypt and the US, and (5) expected differential between the inflation rates in Egypt and the US. Having detected a long-run equilibrium relationship, a vector error-correction model (VECM) was estimated. The generated forecast error variance decomposition shows that the expected inflation differential is the most important contributor to the variation in the differential between domestic and foreign 3-month Treasury bill rates. To the best of our knowledge, international financial integration has not been 1 A country’s de facto financial integration may deviate from its de jure status. According to Bekaert and Harvey (1995), markets may turn out to be more financially integrated than one might expect based on prior knowledge of capital restrictions, whereas other markets seem segmented even though their capital markets are accessible to foreign investors. 2 investigated empirically for the Egyptian case, specifically in the context of macroeconomic management. Thus, this paper contributes to understanding one of the important elements of Egypt’s macroeconomic environment, through: • Empirically quantifying the de facto degree of Egypt’s international capital mobility (financial integration). In doing so, we also gauge the extent to which monetary autonomy is maintained, in the face of a stable exchange rate. • Measuring the relative importance of macro determinants affecting the degree of Egypt’s international financial integration. Empirically quantifying Egypt’s degree of de facto capital mobility is important in designing macro policies; understanding how these policies succeed in affecting aggregate demand, and clarifying to what extent de jure (versus de facto) capital openness has implications for the effectiveness of macro policies. This paper is organized as follows: After the introduction in Section I above, Section II provides an overview of the main areas of the Egyptian economy that are relevant to the study of international financial integration: (1) the gradual de jure liberalization of the capital and financial account of Egypt's balance of payments, and (2) the evolution of the domestic interest rate in Egypt, as well as that of the US. Thus the purpose of this section is to give a picture of the macroeconomic context that guides our empirical investigation. Section III is dedicated to the literature review on the approaches to measuring de facto international financial integration that are later applied in the empirical section. Section IV presents empirical findings of this study based on the UIP test, the test of monetary autonomy, and the cointegration/VECM analysis. Section V concludes.
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